The law governing California real estate investment, development, and secured lending evolves in real time | Lessons from the courtroom battlefront

In a prior post, Respect the Remedy of Rescission in Real Estate Disputes, I highlighted the often under-appreciated remedy of rescission. With rescission, both parties are restored to their pre-contract positions and issues of breach are eliminated. Depending on the facts, rescission is sometimes more advantageous than recovering damages for breach.

The facts: real estate fund buys home at foreclosure sale, then learns the property lacks electricity and necessary easements

DM Residential Fund II, LLC (“DM”) did what many real estate funds do — buy homes out of foreclosure. DM bought a relatively new home at a nonjudicial foreclosure sale (trustee’s sale) initiated by First Tennessee Bank National Association (“FTB”).

Shortly after the sale, DM discovered that the property lacked a utilities easement needed to provide electrical service to the home, and also lacked a certificate of occupancy.

Over the next two years, in the Ninth Circuit’s words, DM “took actions inconsistent with unwinding the contract, including encumbering the property, building improvements, and attempting to sell it.” Then, after two years had passed, DM sued FTB for rescission and other claims.

District court and Ninth Circuit both hold: too late to rescind!

The district court granted FTB’s motion for summary judgment, finding DM was not entitled to the equitable remedy of rescission due to its two year delay.

The Ninth Circuit affirmed. The court started by citing the statutory language from California Civil Code section 1691: a party seeking rescission must do so “promptly upon discovering the facts which entitle him to rescind.” The court then held that after paying $624,000 for a home and then quickly learning of the electrical easement issue, it was not reasonable for DM to delay investigating and pursing its rescission claim for two years.

The fact that the sale was a nonjudicial foreclosure sale, the court held, did not affect DM’s duty to investigate FTB’s potential knowledge of the property’s problems. That’s because under California law, a foreclosing lender has the same duties of disclosure as any other seller. (See, e.g., Karoutas v. HomeFed Bank (1991) 232 Cal.App.3d 767.)

In addition, FTB presented evidence that when DM contacted the former owner of the property, she informed DM that FTB knew of the electricity problem at the time of the foreclosure sale. The court held that by not following up on this lead, and instead taking actions affirming the sale (like building improvements and attempting to sell the property), DM affirmed the sale and forfeited its right to rescind.

The dissent: foreclosing lenders are not normal sellers

The dissent argued that had it been an ordinary sale (instead of a foreclosure sale), DM would have had strong grounds to suspect the seller knew of the defect, because property owners normally occupy and improve the property and are exposed to its physical condition. The dissent went on, “But this was a foreclosure sale. The seller bank didn’t occupy the property or have any other physical dealings with it; the property was an asset on the bank’s books securing a defaulted loan.”

The dissent acknowledged that foreclosing lenders have the same duty of disclosure regarding the property as any other seller, but argued that under the “foreclosure sale” circumstances DM would have little reason to suspect wrongdoing by FTB, and therefore did not unreasonably delay pursuing its claim for rescission. The dissent urged the full Ninth Circuit to certify the case for consideration by the California Supreme Court.

Lesson

If a serious problem arises after buying property — whether at a foreclosure sale or through any other real estate transaction — evaluate and act on your remedies quickly and with purpose.

Rescission must be exercised promptly after discovering the key facts.

Waiting too long in this case ended DM’s opportunity to rescind. A shorter delay — say one year instead of two — might have allowed the case to survive summary judgment. But the reasonableness of the one year delay would still ultimately be decided at trial.

The best course is to act quickly in a well-documented manner, so that delay isn’t an issue at all. That way, the trial can focus on the real issues of whether rescission is justified and how to restore the parties to their prior positions.